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Bailout

A bailout is a colloquial pejorative term for giving a loan to a company or country which faces serious financial difficulty or bankruptcy. It may also be used to allow a failing entity to fail gracefully without spreading contagion.[1] The term is maritime in origin being the act of removing water from a sinking vessel using a smaller bucket.[2]

Overview

A bailout could be done for mere profit, as when a predatory investor resurrects a floundering company by buying its shares at fire-sale prices; for social improvement, as when, hypothetically speaking, a wealthy philanthropist reinvents an unprofitable fast food company into a non-profit food distribution network; or the bailout of a company might be seen as a necessity in order to prevent greater, socioeconomic failures: For example, the US government assumes transportation to be the backbone of America’s general economic fluency, which maintains the nation’s geopolitical power.[3] As such, it is the policy of the US government to protect the biggest American companies responsible for transportation (airliners, petrol companies, etc.) from failure through subsidies and low-interest loans. These companies, among others, are deemed “too big to fail” because their goods and services are considered by the government to be constant universal necessities in maintaining the nation’s welfare and often, indirectly, its security.[4][5]

Emergency-type government bailouts can be controversial. Debates raged in 2008 over if and how to bail out the failing auto industry in the United States. Those against it, like pro-free marketradio personalityHugh Hewitt, saw this bailout as an unacceptable passing-of-the-buck to taxpayers. He denounced any bailout for the Big Three, arguing that mismanagement caused the companies to fail, and they now deserve to be dismantled organically by the free-market forces so that entrepreneurs may arise from the ashes; that the bailout signals lower business standards for giant companies by incentivizing risk, creating moral hazard through the assurance of safety nets (that others will pay for) that ought not be, but unfortunately are, considered in business equations; and that a bailout promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout.

Others, such as economist Jeffrey Sachs[6] have characterized this particular bailout as a necessary evil and have argued that the probable incompetence in management of the car companies is an insufficient reason to let them fail completely and risk disturbing the (current) delicate economic state of the United States, since up to three million jobs rest on the solvency of the Big Three and things are bleak enough as it is. In any case, the bones of contention here can be generalized to represent the issues at large, namely the virtues of private enterprise versus those of central planning, and the dangers of a free market’s volatility versus the dangers of socialist bureaucracy.

Furthermore, government bailouts are criticized as corporate welfare, which encourages corporate irresponsibility.

Governments around the world have bailed out their nations’ businesses with some frequency since the early 20th century. In general, the needs of the entity/entities bailed out are subordinate to the needs of the state.

Themes

From the many bailouts over the course of the 20th century, certain principles and lessons have emerged that are consistent:[7][8][9][10]

Let insolvent institutions (those with insufficient funds to pay their short-term obligations or those with more debt than assets) fail in an orderly way.

Understand the true financial position of key financial institutions, through audits or other means. Ensure the extent of losses and quality of assets are known and reported by the institutions.[11]

Banks that are deemed healthy enough (or important enough) to survive require recapitalization, which involves the government providing funds to the bank in exchange for preferred stock, which receives a cash dividend over time.[12]

If taking over an institution due to insolvency, take effective control through the board or new management, cancel the common stock equity (existing shareholders lose their investment) but protect the debt holders and suppliers.

Government should take an ownership (equity or stock) interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later. In other words, the government becomes the owner and can later obtain funds by issuing new common stock shares to the public when the nationalized institution is later privatized.

On November 24, 2008, American Republican Congressman Ron Paul (R-TX) wrote, “In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me…. It won’t work. It can’t work… It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians.”[14]

Costs

In 2000, World Bank reported that banking bailouts cost an average of 12.8% of GDP.[15] The report stated:

Governments and, thus ultimately taxpayers, have largely shouldered the direct costs of banking system collapses. These costs have been large: in our sample of 40 countries governments spent on average 12.8 percent of national GDP to clean up their financial systems.